Bar News - February 19, 2014
Tax Law: Transferring a Patent? Consider the Taxes
By: Ross Krutsinger
When transferring patent rights, most other terms of the agreement are usually determined before the parties begin discussing a license royalty rate. For a sale or assignment of a patent, the price is generally the controlling term. However, one must also consider the tax consequences of a patent transfer, because this factor may impact the nature of the transfer and the amount of income the patent holder receives after taxes.
Section 1235 of the Internal Revenue Code states that a transfer by a patent holder of all substantial rights in the patent is treated as a sale or exchange of a capital asset held for more than one year, i.e., as a long-term capital gain. For year 2013, long-term capital gains are taxed at 15 percent, compared to marginal tax brackets of up to 39.6 percent. Thus, applying §1235 can provide substantial tax benefits.
One benefit of §1235 is that the holder receives more after-tax income, due to the lower tax rate of long-term capital gains compared to ordinary income tax rates. For $1 million of income in 2013, for example, the holder’s after-tax income is about $140,000 more when taxed as long-term capital gain than when taxed as ordinary income ($781,000 vs. $641,500). This increase in after-tax income is similar to a boost of about 20 percent in licensee performance. These examples take into account applicable 2013 federal taxes only and assume no other income.
A second benefit of §1235 is that the holder has the option to offer a lower royalty rate to the licensee, without reducing the amount of after-tax income. Consider $20 million of licensee revenue subject to a 5 percent royalty. Before taxes, the royalty amount due to the licensor is $1 million. The licensor’s after-tax income is about $813,000 when taxed as ordinary income. This amount is equivalent to the after-tax income for a royalty rate of about 4.065 percent, taxed as a long-term capital gain (also about $813,000). Thus, the holder may strategically use §1235 to offer a lower royalty rate to the licensee without reducing after-tax income.
Third, §1235 allows the patent holder to take advantage of the tax rates for long-term capital gains, without concern over holding the patent for one year or more. The holder therefore has the ability to act quickly to transfer a newly-acquired patent and still receive preferential tax treatment. This benefit also eliminates the questions of whether the patent has been held for one year or more.
To benefit from §1235, however, one must keep in mind that it does not apply to all patent transfers or licenses. Several requirements must be met, namely, (1) transfer of a patent, (2) the transfer is for all substantial right or an undivided interest therein, and (3) by a holder. Each of these requirements is discussed below.
A transfer can be to a person or business entity, but cannot be by gift, inheritance, or device. Section 1235 does not apply, however, to transfers directly or indirectly to someone related to the holder as defined under §267(b) (related persons) or to a partnership owned more than 50 percent by the holder or by a related person. Thus, §1235 would not apply to a transfer by an inventor to an LLC in which the inventor is a majority owner.
All substantial right
The holder must transfer all substantial right in the patent or an undivided interest in the patent that includes a part of all such rights. This typically is done by way of an assignment or an exclusive license for the remaining life of the patent. Section 1235 would not apply to a patent license having geographic limitations, a license term of less than the entire remaining patent life, a license with field-of-use limitations, or rights to less than all inventions covered by the patent.
Only some rights are considered insubstantial and, therefore, would not render §1235 inapplicable. A transferor’s right to terminate or revoke the exclusive license for events beyond the control of the transferor is not substantial. On the other hand, the right to terminate a license at will and the right of the holder to practice the invention each are examples of a substantial right that negates §1235 treatment.
By any holder
The Treasury Regulations define “any holder” as an individual whose efforts created the property, including an inventor or joint inventor as defined under the patent law. When a patent has joint inventors, each joint inventor holds an undivided interest in the patent; therefore, each joint inventor can be a holder. The holder may also be an individual other than a relative or employer of an inventor who acquired rights to the invention in exchange for value prior to reducing the invention to practice.
Timing and Use of § 1235
The “transfer” requirement may determine if and when a holder assigns his rights in a patent to a business entity or instead keeps the rights in the inventor’s name. The “all substantial right” requirement may determine whether a license is a sole, exclusive, or non-exclusive license, as well the license term and presence of any restrictions. The “holder” requirement determines who may benefit from §1235.
Section 1235 applies to income received from patent transfers, regardless of whether payments are made periodically over time or whether payments are contingent on the productivity, use, or disposition of the patent. Thus, §1235 applies to a single payment, fixed periodic payments, and periodic payments based on performance. Considering the 2014 change in long-term capital gains rate to 20 percent for the marginal tax bracket of 39.6 percent, one could strategically structure license payments over time for maximum tax benefit.
The benefits of §1235 can be used for improved financial position or as a negotiating tool in patent transfers. Therefore, the tax consequences of a patent transfer should be considered in context of the holder’s entire tax picture, in addition to the holder’s business goals and other terms of a patent license agreement.
Ross K. Krutsinger is an intellectual property attorney at the Manchester office of Mesmer & Deleault, where he represents clients in patent, trademark, copyright, trade secret, and business matters. Contact: firstname.lastname@example.org; 603-668-1971.